Trend Trading with the VIX

But what if we want to be more than “just friends?” What if we want the trend to drop her drawers and dance naked on our bed? Today, I would like to introduce the VIX. A potent and sometimes powerful “love potion” that might just work magic in your favor.

Furthermore, I would like to talk about trading strategy automation. How we can use modern tools to make life, and trading a little easier.

A Workable Trading Strategy

Today’s article is a trading strategy session. A trading system for the Emini SP500 futures contract. Complete with exact entry and exit rules with accompanying statistics.

This trading strategy is a follow-up article to ‘Intraday Trend Trading: Is the Trend Really Your Friend?‘ If you did not read that article, shame on you. That article serves as the starting point, and this article serves as the follow-up. If you continue, without reading and understanding the original concept, then much of this will seem very confusing.

In that article, I defined a broad market bias in the stock index futures market.

Essentially, I presented statistical evidence that trading in the direction of the primary trend is a valid approach. This article is going to take that clearly defined market bias, and improve upon it. Without curve fitting or over optimization.

At the end of this article, you will be able to deploy and (hopefully) profit.

Introducing the VIX or Volatility Index

Most people have no idea what is the VIX. The VIX is a volatility calculation of the options contracts that are traded at the CBOE, or Chicago Board Options Exchange.

The VIX is recalculated every 15 seconds throughout the trading day. The VIX is a standard feature on nearly all modern trading platforms.

What exactly is the VIX? In a nutshell, it is a volatility calculation of the nearest options contracts prices for the stocks contained within the SP500. The VIX serves as a quick and dirty way for market participants to judge whether stock options prices are moving aggressively, quickly, or slowly.

The VIX also serves as a proxy for stock market direction. Generally speaking, when the VIX is UP, then the stock market is DOWN. And when the VIX is DOWN, the stock market is UP. I have included a visual below.

At first glance, the inverse relationship of the VIX appears to be 100% constant. To the casual observer, it looks like a seesaw. When the stock market swings lower, then the VIX swings higher, etc.

However, this is not always true. In fact, the relationship is valid only about 80% of the time.

The VIX is not a perfect predictor of future stock market price direction or stock options pricing volatility. However, in the land of the blind, the one-eyed man is king. So we are going to attempt to use this somewhat confusing, arcane, obfuscated and imperfect measurement tool as a filter for our trading system. We are not interested in the daily movements. We are only interested in “shock” movements of the VIX. Specifically, when the VIX crashes lower by < -4% intraday.

When the VIX crashes lower by < -4% intraday, we are seeing two things happening:

Stock prices are moving higher

Options volatility is decreasing

The ‘secret sauce’ is the combination of both. The rapid movement of both, moving in the same direction.

Let’s now move into the strategy rules.

Trading Strategy Rules

Wait 2 hours.

If the intraday VIX is down < -4%.

Calculate the middle point of the intraday range.

If a 5-minute bar crosses above the mid-point, then buy at the market.

Exit the trade for whatever profit at the end of the trading day.

Exit the trade for a loss if a 5-minute bar crosses below the mid-point of the day.

Trading Strategy Results: Stock Index Futures

Results for the Emini SP500 are as follows:

Profit Factor 1.72

Total Trades 441

Ave Trade $65

Max Drawdown $2,750

Let plunging options volatility pricing work in your favor.

Results for the Emini Russell 2000 are as follows:

Profit Factor 1.80

Total Trades 468

Ave Trade $51

Max Drawdown $1,880

As you can see, the results are quite robust. However, this is just the tip of the iceberg. The truth of the matter is that I have only touched the surface of this concept. We can dig even deeper, and show yet more profitable trading strategies. With even more robust equity curves. That are nearly 100% accurate and are so compelling that your mouth with water with anticipation.

But I will not give away the entire store. Rather, I hope to inspire you. To get off your ass and start programming these basic concepts. To take control of your own destiny. Build your own trading models that are deeply rooted in science, common sense and valid theory. To veer away from the incredibly ridiculous world of magical trading indicators.

Trading System ON/OFF Switch

One thing that drives me crazy about trading system vendors, they never talk about when to turn a trading system OFF. All things change, especially financial markets. What is great theory today, will soon enough be a terrible theory. Will drain your account to nothing. So you have to have a method that turns a trading system off.

There are so many opinions of when to turn a trading system OFF. But I have discovered that by keeping things simple, and not overcomplicating, we can achieve a pretty good result. My own method is sort of like using a hammer in a sword fight. To put it plainly, I use a 100 period moving average of the equity curve. It’s not perfect, but it works for me.

Once the equity curve breaks the 100-period moving average, then it’s time to shut it down. On the above charts, you will see a blue line which represents a 100-period moving average of the equity curve. During periods of low volatility and underperformance, the system will shut down. But when volatility begins to rear its fearsome head, the system starts kicking off profits, and the equity curve shoots higher (hopefully).

The Importance of Automation

With the above strategy, a signal will fire off a trade only 2 or 3 times per month. However, some months might fire off 15 trades. The truth is that nobody really knows when plunging options volatility pricing will occur. The VIX resets every 15 seconds. So you have to have a regime that is constantly waiting for this situation.

Automated trading solves this problem.

A Stable of Automated Strategies

Finding these bits and pieces of an exploitable market edge are not easy. You need to think in terms of running a casino. Your strategies are just little slot machines, all lined up, waiting for someone to insert their money. To take the opposite side of your trade.

Since markets are always in a state of change, you need trading strategies that work across a broad spectrum of environments. You need strategies that exploit not just the stock market, but also currencies, and commodities. Use modern computing to find only the choicest, most juicy trading scenarios.

Conclusion

Thanks for reading today. A bit of a long article. With a technical aspect, which requires clarity in explaining a complicated, multifaceted scenario. These sorts of topics, I am not very good. I apologize if I confused you.

If you need any help with strategy development or just an opinion. Please do not hesitate to contact me. I can program most any idea in a few minutes.

I will leave you with a breadcrumb, that might lead to the bakery. In the above strategy, we explored the stock index futures contracts. But these stock index futures are just groups of stocks. Try this strategy on subsector ETF’s, or individual stocks. You might find something truly amazing.

Hi Emmett, when you say it is stupid simple, do you mean you don’t need any programming knowledge whatsoever?

Because of your reviews, I got interested in Kevin Davey’s work, but it seems I might have to point in another direction as a newbie because in order to follow what he preaches I would need to know about programming…

Also, and I apologize for being off topic in this thread, what day trading strategy could you recommend me to investigate? Please note that I’m just starting in this world.

Thanks for your advice and the great work you’ve put into this website!

You are not off topic. Actually, you are completely on topic. The hard and simple truth is that you MUST learn to program strategies. You must learn to backtest. You must learn this crucial element not to find ‘what works’ but to discover what does not work. Nearly all of my time is spent disproving theories. Every once in awhile…you will find something that works and is robust. But it’s hard work. The problem with the vast majority of the trading platforms that offer backtesting is that you must learn C#, R, Python, .Net, or Java. But let’s get real…to… Read more »

Hi Emmet I´ve read with enjoyment your two articles about this Vix strategy and the Intraday trend trading. I find them really simple and loaded with objectivity as well as a great backtesting. Thank you! An idea came to my mind after reading your two articles. What do you think about implementing this same strategy but adding the VWAP (volume weighted average price) to the backtesting on ES? I use to trade using price-action and volume as a guidance, and I thought that the VWAP may be the “primary trend of volume of the day”, similar to the mid-point range… Read more »

Hi Emmett, I am finding the following statement a little confusing : “If a 5-minute bar crosses above the mid-point, then buy at the market. ” – Assuming we are trading emini S&P500 as an example, do we mean if emini S&P500 crosses above mid-point here ? or if VIX crosses above mid point? . I thought VIX is being used for reference so it would be emini BUT Since VIX went down so emini would have gone up, so now emini would have to go down to cross the mid point.

Hi Emmett, Thank you for your informative and well written article. You mentioned that you have cheap laptops for back testing and also a long time ago you said you use a certain platform to back test even if you don’t know programming although more recently you said that you wouldn’t recommend it. Can you walk us through how to backrest what platform to use and how to find data etc. Also how an American citizen can legally sign up for the cheap overseas brokerage for ETFs? Thank you so much. Also is your email Emmett tradingschools.org? I’d prefer not… Read more »

Thx for the further update on this strategy. What is the win/loss percentage for total trades taken. Also, is this only LONG strategy. Lastly, do the results show or include allocations for slippage. Although for 3-4 trades on average month, slippage should mean little. Thx again!

So … questions: 1. If the blue line is the equity, what is the red line? 2. The system works only if the intraday VIX is down 0 – 4%, but not if it’s down let’s say 6%? If it’s 6%, stay out? 3. Do you recalculate the middle point of the intraday range the entire trading day? (important for calculating the SL) 4. Does “a 5-minute bar crosses above the mid-point” mean “low of the bar is above mid-point” like in the previous method? 5. What if at 11:30am when I’m doing all these calculations the price has been… Read more »

Hi Goagal, 1. The red line is the equity curve. The blue line is a 100 period moving average of the equity curve. When the equity curve pierces the moving average, then the system needs to shut itself off. 2. The system needs for the intraday VIX to be down a minimum of -4%. Yes, you can be more selective (-6% etc) and achieve results over $100 per trade, but you sacrifice sample size, which increases the likelihood of a random outcome. 3. The middle point is a dynamic calculation, it recalculates as new intraday highs and lows are achieved.… Read more »

Personally I short TVIX as a long-term investment. Short interest is only 3% and seems like there are always shares available. It goes down a lot so you will continually need to add to your short positiion.

Your whole post is a study in why TR fail, and why so many traders fail too. You say, “With the above strategy, a signal will fire off a trade only 2 or 3 times per month. However, some months might fire off 15 trades.” Huh? With all those dreamy-eyed newbies and unrealistic traders looking not to think and trade, but just copy someone else’s trades? To come and sit down day after day and not take any trades? The TR operator will start forcing trades, just to satisfy the punters, then BOOM, everything blows up, and we have the… Read more »

I hear you RobB. I could sniff out the b__ks disease even in his pathetic attempt to hide his manic persona. I wouldn’t be surprised by now if he was actually Pete. He not only lost credibility now calling out supposed trades and flirting with the idea of starting a monthly churning shamshow site , but before as dtchurnNO and dtchum when they were trolling on the side of the shams which makes his words even more untrustworthy.

Your post reminds of what I keep saying and many folks do not get it when I say it. The TR set up a pure fantasy world and most folks rather lose money trading in that fantasy world, whereby one with a small account makes a salary like clockwork from day trading, than have at least a chance to make money trading in the real world. I will also add as an engineer with a math background and who did data analysis for a living, that it is easy to do data manipulation to come up with a system that… Read more »

The system works across all VIX % regimes. But you need to find the sweet spot in terms of sample size vs trade size. For instance, you can be more selective and require the VIX to be down 8%, and your profits go way up. But you lose sample size. I like to see a minimum of 300 sample size. This eliminates the possibility of randomness.

1. Can you walk us through how to backrest what platform to use and how to find data etc. If we don’t know how to program?… 2. Also how an American citizen can legally sign up for the cheap overseas brokerage for ETFs? Thank you so much. 3. Also is your email [email protected]? Thanks for your reply Rob and looking forward to your reply Emmett.

Regarding the backtest platform, I will set up a new page with the platform and code that you can import onto the platform. That way you can backtest, play with the code, test different symbols, etc. Just give me a couple of days to get that together.